COVID-19 Shock to the Economy

Global economic activity is being deliberately frozen to stem the
coronavirus pandemic. This initial shock is very sudden and deep. Yet
what matters for asset pricing is the cumulative impact of the growth
shortfall over time. We believe that policy actions to cushion the
impact of virus shock are nothing short of a revolution. Execution
remains a risk, but if successful, the cumulative impact of the virus
even under the currently most bearish forecasts would be well below that
seen in the wake of the 2008 global financial crisis (GFC) — despite
the historic scale of the initial shock.

A banking crisis and overextended household balance sheets led to a
“lost decade” of deleveraging after the GFC. This time, the immediate
shock is much deeper, but the financial system is not in crisis for the
moment. The propagation of the shock is directly linked to the evolution
of the virus and the duration of containment measures, in our view.
Current economic forecasts, including the most pessimistic, imply
long-run economic consequences that are much less severe than the
post-GFC impact in both the U.S. and euro area, as the chart shows. The
cumulative GDP shortfall in the years that followed was ultimately
equivalent to 50% of 2007 GDP in the U.S. For the current shock to be on
a similar scale, it would have to morph into a financial crisis, in our
view. For now, we see the much swifter and greater fiscal and monetary
response this time limiting this risk.

The pandemic has triggered an abrupt, deliberate stop to economic
activity. We believe the concept of “recession” doesn’t’ apply here
because this is not resulting from the evolution of a usual business
cycle. The current shock is more akin to a large-scale natural disaster that
severely disrupts near-term activity, but eventually results in an
economic recovery. The large and immediate loss of income needs to be
addressed with a comprehensive policy response, including a new suite of
policy measures designed to help bridge cash flow pressures by
backstopping household incomes and small businesses – without which the
economy could suffer permanent damage. We have seen these measures –
both monetary and fiscal – coming together quickly and on unprecedented
scale, especially in key developed economies.

A key risk to our view is policy execution.

A recent example shows the difficulty of delivering the aid to those
in need: A $350 billion loan program for distressed small businesses in
the U.S. quickly reached its limit, with evidence that the smallest
businesses had severe difficulty accessing the program. There is also
the risk of permanent damage if the freezing of economic activity lasts
for an extended period of time – especially if ongoing policy support
loses momentum. An extended interruption could morph into a financial
crisis if it were to lead to an unprecedented wave of corporate
insolvencies, putting pressure on the banking system. Last week’s oil
price collapse – partly caused by the ongoing drop in demand caused by
the economic contraction – illustrates the outsized near-term knock-on
effects of halting economic activity.

Bottom line

The initial risk asset response in 2020 – with equities down 30-40%
across the world – has been on an order of magnitude similar to the
financial crisis. The entire range of current forecasts imply the
current economic shock is less severe given much greater fiscal and
monetary support this time around. Yet effective implementation of such
policy support is critical, and we remain cautious over a tactical
horizon due to the substantial near-term uncertainty on the evolution of
the virus and containment measures. We mostly stick to benchmark
holdings on an asset class level, and generally prefer credit over
equities given bondholders’ preferential claim on corporate cash flows.
We prefer U.S. Treasuries to lower-yielding peers as portfolio ballast.
Quality equities and a focus on sustainability also can provide
portfolio resilience.

Courtesy of Jean Boivin, PhD,is Head of the BlackRock Investment Institute. He is a regular contributor to The BlackRock Blog.